Openness, Government Size and the Terms of Trade

Abstract

This paper investigates the relationship between trade openness and the size of governments, both theoretically and empirically. We argue that openness can increase the size of governments through two channels: (1) a terms of trade externality, whereby trade lowers the domestic cost of taxation, and (2) the demand for insurance, whereby trade raises risk and public transfers. We provide a uni ed framework for studying and testing these two mechanisms. Our main theoretical prediction is that the relative strength of the two explanations depends on a key parameter, namely, the elasticity of substitution between domestic and foreign goods. Moreover, while the rst mechanism is ine¢ cient from the standpoint of world welfare, the second is instead optimal. In the empirical part of the paper, we provide new evidence on the positive association between openness and government size and we explore its determinants. Consistently with the terms of trade externality channel, we show that the correlation is contingent on a low elasticity of substitution between domestic and foreign goods. Our ndings raise warnings that globalization may have led to ine¢ ciently large governments. JEL Classi cation: F1, H1 Keywords: Openness; Government Size; Terms of Trade Externality; Elasticity of Substitution between Imports and Exports. We are very grateful to Jaume Ventura for many insightful discussions. We also thank Daron Acemoglu, Pol Antras, Roland Benabou, Alessandra Bon glioli, Giovanni Bruno, Carlo Devillanova, Jordi Gali, Philippe Martin, Fabrizio Onida, Torsten Persson, Rick van der Ploeg, Dani Rodrik, Michele Ruta, Guido Tabellini, Fabrizio Zilibotti and seminar participants at Harvard, MIT, the NBER SI 2006, the CEPRESSIM 2006, CREI, UPF, the European University Intitute, Bocconi University, Warwick University, Paris 1-Jourdan, the University of Zurich, the Franco Modigliani Workshop in Rome, the third CEPR-RTN conference on Trade Industrialization and Development, the EEA Meetings in Vienna, the IADB conference in Kiel and the CSGR conference on the Future of Global and Regional Governance for comments. All errors are our own. Gino Gancia thanks the Spanish Ministerio de Ciencia y Tecnologia (grant SEC200203816), and the RTN grant "Macroeconomic Policy Design for Monetary Unions" for nancial support. yCESPRI, Università Commerciale Luigi Bocconi, via Sarfatti 25, 20136, Milano (Italy). E-mail: paolo.epifani@unibocconi.it zCREI, Universitat Pompeu Fabra and CEPR, Ramon Trias Fargas, 25-27, 08005, Barcelona (Spain). E-mail: gino.gancia@upf.edu